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Investment, Time, and Insurance 14

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At the end of May 2012, the Dragon C2 spacecraft made history by docking with the International Space Station. This was the first time a private company, rather than a government, was able to launch a craft into orbit and dock it with the station. SpaceX, the company that built both the Dragon and its launch vehicle, the Falcon 9 rocket, had spent a reported $1.2 billion to achieve this milestone. The mission’s success led NASA to award over $1 billion in contracts to SpaceX to conduct additional missions.

The economics behind SpaceX’s initial decision to design and build the Dragon and Falcon contain two interesting features that have been missing from our analyses to this point. The first is the element of time. SpaceX was formed in 2002 (by Elon Musk of Tesla fame), 10 years before the mission it was founded to achieve. It had to spend vast sums of money developing its products before it could receive payback for them. The second feature is uncertainty. In 2002 no one at SpaceX knew for sure whether the mission would ever be technically or financially successful. Yet over the 10-year span between the founding of the company and the successful mission of the Falcon and the Dragon, SpaceX managers had to make hugely consequential decisions without a sure sense of how things would turn out. Indeed, in 2014 a test flight for Richard Branson’s private spaceflight venture Virgin Galactic crashed in the Mojave Desert upon takeoff.

Things have turned out well for SpaceX, however. It continues to conduct missions for NASA, resupplying the International Space Station on a regular basis. While missions to this point have only carried cargo, SpaceX designed the Dragon to carry people and plans to lead missions that will take astronauts to the station. SpaceX is currently trying to figure out how to reduce costs by reusing rocket engines that land themselves on barges in the ocean after delivering their loads.

The decisions SpaceX faced, and the inherent elements of time and uncertainty involved, are like many decisions that firms and consumers face every day. In this chapter, we explore economic decisions involving time and uncertainty. We pay particular attention to two types of decisions, those involving investment and insurance.

Investment is the purchase of capital now with the intent of getting future benefits from it. A retail firm’s construction of a new store is an example of investment. The firm pays the up-front costs of building it in order to earn future profits from sales over the store’s lifetime.1 We learn how payoffs that occur at different times can be valued on an equal basis, and discuss how to account for the riskiness that might be associated with future payoffs from capital investment. We also see how interest rates, which play a critical role in evaluating capital investment decisions, are determined in the investment capital market.

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Insurance can be thought of as one economic actor paying another to reduce an economic risk facing the payer. Consumers and firms buy all types of insurance to reduce the risks they face. We explore why they are willing to do so and how much they are willing to pay to reduce risks.